SFB 303 Discussion Paper No. B - 066
Author: Weissenberger, Edgar, Gerd Müller-Brockhausen, and Heinz Welsch
Title: A Factor Demand Model with Quasi-Fixed Factors and Rational Expectations
Abstract: The introduction of quasi-fixed factors in factor demand models has been very popular in recent empirical
demand studies. These studies can be grouped into two categories. The first is flexible functional form models
that permit quite general substitution possibilities but impose the static expectations assumption about prices and
output (see for example Berndt, Fuss and Waverman (1980) or Morrison and Berndt (1981)). The second puts
the emphasis on expectations formation with only rudimentary treatment of the technological structure (the
prototype in this category is Sargent (1978)). The main finding of these studies is that one has to distinguish
short-run and long-run adjustment and that the assumption of all factors being variable represents a gross
violation of the data.
In a recent study Pindyck and Rotemberg (1983) estimate a dynamic factor demand model
under the assumption of rational expectations by estimating the Euler equations directly. They do not, however,
utilize an explicit solution to their model, nor do they test the validity of the restrictions implied by the rational
expectations hypothesis (hereafter REH). In a footnote Pindyck and Rotemberg point out that the test of the
overidentifying restrictions indicates rejection of their model. It is well-known that the stochastic error of a first
order optimality condition will typically exhibit serial correlation rendering OLS estimates inconsistent (for
example see Muellbauer and Winter (1980)). Sargan (1982) has pointed out that the efficiency of instrumental
variable estimates from such equations is doubtful. We believe that this justifies yet another empirical study on
factor demand. The advantage of our method over that of Pindyck and Rotemberg is that we are able to estimate
the explicit solutions jointly with the stochastic processes of the informational variables, subject to the cross-
equation REH-restrictions.
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Creation-Date: February 1986
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